I first got into finance and investing almost 20 years ago when I opened my first brokerage account at Ameritrade and read the book, One Up on Wall Street, by Peter Lynch. Since then I've read countless books on the subject, took many classes and helped individuals and families with their finances. Most of what you need to do to create wealth is contained in the principles below. The principles shouldn't be earth shattering, they are simple to understanding, simple to execute, however hard to maintain.
1. We don't save enough
The paradigm in the United States needs to be shifted from spending first and saving what is left over (if anything) to saving first and foremost. One of my favorite books on creating wealth is The Millionaire Next Door, by Thomas Stanley. Stanley studied millionaires and multimillionaires in the US and found that on average they saved 20% of their income. The personal savings rate in the U.S currently sits at 4.4%, which means that millionaires are saving nearly 16% more than the average person is. That extra 16% is enormous when it comes time to retire. For example, a 30 year old making $75k a year that saves 20% in their 401k earnings 6% would have $1.67 million in their plan at age 65. Contrast that with the average saver who is looking at $368k when they retire.
Before we look at the principles 2-5 below, which focus on investing, it is critical that you start saving more. The only way to be able to go from saving 6% to saving 20% is to an aggressive, detailed approach to where your money is going each month. The best place to start is purchases, and the leaks in your spending habits will become evident. I can't count how many times people say I don't know where my money goes each month. This approach is the best way to find out. There may not be areas where you can save thousands per month in one shot, but if you save a hundred here and a hundred there it will very quickly add up to thousands in savings. Those thousands can then start working for you rather than for someone else. companies at a bargain price, and then ride the company to success. Lynch in his books Learn to Earn and One Up on Wall Street to ignore the analysts and talking heads on TV and he encourages the reader to do research to find stocks that you understand and believe in.
2. Invest in what you know
Investing can be intimidating, from newspaper articles and media coverage detailing how millions will no longer be able to retire, to the angry man on television yelling "booyah!" it's no wonder that so many people are hesitant to take the leap into investing. For many otherwise intelligent, confident people, the idea of risking hard-earned cash in a market they don't truly understand just doesn't make sense. Often people feel more comfortable sitting down at a blackjack table! The truth is you may have an advantage over Wall Street when it comes to investing-your personal area of expertise.
There are countless strategies and philosophies when it comes to investing. Two of the most successful investors of all time, Warren Buffet and Peter Lynch have the same, simple, philosophy. They find good by spending a couple of months and track where every dollar that you spend goes. By taking this disciplined approach, you are less likely to make impulse
When doing your own research, Lynch states the following are five positive signs to look for in a company:
- A low price-to earnings- ratio, especially as compared to similar companies
- A low percentage of institutional investors
- Insiders buying the company's stock
- The company buying back it's own stock
- A low debt-to-equity ratio, especially as compared to similar companies
If you find a stock that looks really good according to the numbers, don't invest just because of the numbers. Make sure you can describe why this business is a good business and why you're buying this stock - and the fact that the stock is going up is not a good enough reason alone.
This simple strategy is one of my favorites, but it is not infallible. Like any type of market, sometimes you may find a good company with a great story, but the markets in general move against you.
3.Stop being a bandwagon investor
Studies have shown that investors who try to time the market end up selling at the wrong time - when the market is down - reducing their overall returns. Sticking to a strategy especially when the when the markets are going down against your investments is extremely challenging. Fidelity did a study analyzing participant actions from October1, 2008 through the second quarter of 2011. 401k investors who moved their assets to cash during the 2008-2009 downturn and stayed invested in cash achieved a 2% gain as of June 30, 2011. Those who stayed fully invested ie, stayed put, achieved an increase of 50% during the same time period. Investors who sought "help" ended up having average returns almost 3% higher than those that didn't, but since I'm an advisor and don't want to seemed biased we won't focus on that aspect of the study.
The following is an illustration from Carl Richards's book, The Behavior Gap, that shows what too many investors go through trying to time the market.
When trying to time the market most people make the same mistake over and over again: They buy high, out of greed, and sell low, out of fear, despite knowing on an intellectual level that it is a very bad idea.
The easiest way to see this behavior in action is to watch money flow in and out of mutual funds. Let's go back to early 2000. The dot-com market had reached a fevered pitch. People were living large and using their home equity to buy tech stocks right after the NASDAQ had a single year return of better than 80 percent!
Then, in January 2000, investors put close to $44 billion dollars into stock mutual funds, according to the Investment Company Institute, shattering the previous one-month record of $28.5 billion. We all know the story from there. Money continued to pour into stock funds, breaking records for February and March and pushing the NASDAQ to 5,000, only to lose half its value by October 2002.
This gets worse. That same October (at the low for the cycle), as investors were selling stocks as fast as they could, where was all the money going? Into bond funds, at a time when bond prices were near record highs.
Think about this pattern for a minute. At the top of the market we can't buy fast enough. About three years later at the bottom, we can't sell fast enough. And we repeat that over and over until we're broke. No wonder most people are unsatisfied with their investing experience.
A better approach would be to determine the mix of stock and bonds that you are comfortable with as an investor and keep investing along those lines. So if you decided that a portfolio of 60% stocks and 40% bonds is the right investment mix for your time horizon, then you should keep your investments in those allocations.
4. Fees Matter
Everything in finance (and just about every other industry) has fees and expenses all over the place. Sometimes they are hard, if not impossible to uncover, but trust me they are there. Over time they add up and can take a chunk out of your portfolio.
I wanted to focus on the fees and expenses contained in mutual funds, since there are about $10 trillion invested in them and because they are sometimes difficult to know what a fund is costing you. In the world of mutual funds, costs are measured by the mutual fund expense ratio. All mutual funds must, by law, disclose the expense ratio to existing and potential investors. But what is the ratio, what makes up the costs that it includes and how does it compare to other types of investments?
A Breakdown of the Costs Included in the Mutual Fund Expense Ratio
- Management Fee: A fee paid to the portfolio management company for investing the money according to the funds objectives. This is often the biggest component cost of the mutual fund expense ratio. Typical management fees run from 0.50% to 2.00%
- Transaction Costs: A mutual fund must pay stock brokers a commission just as do individual investors. Some funds have high turnover (they are always buying and selling investments). In addition, high turnover in a fund's investment portfolio can generate higher capital gains taxes and other expenses
- Custody Costs: Mutual fund companies are required to have their investments held by a custodian bank. These banks are responsible for registering the stocks, bonds, or other securities on behalf of the fund.
- 12b-1 Marketing Fees: These annual marketing and advertising fees are taken from fund shareholders and used to promote the fund for the purpose of raising money. The more money the fund has, the more money the portfolio managers make from their management fee. A 12b-1 fee does absolutely nothing for you as an investor so one piece of advice would be to stay away from funds charging these fees.
- Legal Expenses: Funds must file paperwork to the SEC and other regulators, file incorporation papers, and many other things that require legal expertise.
- Transfer Agent Fees: When a mutual fund shareholder buys or sells part of his investment in the fund, the transfer agent has to deal with the paperwork, money, and account statements. Transfer agents handle the day-to-day work of keeping records for shareholder who own the fund, processing redemption and purchase requests and other responsibilities that are vital to the nuts-and-bolts functioning of the capital markets.
The other large expenses not included in the Mutual Fund Expense Ratio, are Mutual Fund Sales Load: It is nothing more than a commission that goes to the person or institution that convinced you to invest your money. A quick and easy way to see if you have a Sales Load attached to your fund is to look at a statement and see if your fund has either an A, B, or C letter after it. A, B, and C represent different share classes which are essentially how that commission is taken from your account.
The lesson of all of this is to pay attention to the mutual fund expense ratio. It represents real money coming directly out of your own pocket. Ensure the fees you are paying are worth what you are getting from them.
Here is a whitepaper I wrote on 401k plans and the excessive fees they charge. In next month's Wealth Chronicle I will write about some of the recent changes that have been made to 401k plans and how they disclose their fees.
5. The Importance of Diversification
This lesson is brought to you by the employees of Lehman Brothers and Worldcom, two high profile examples of once high flying stocks going bankrupt and their investors lose everything. I see this scenario happen all too often. You work for a public company. They offer you a 10-15% discount on buying their company stock. No one likes to pass up free money, so many people add the company stock as the sole investment in their retirement plan. You work for the same company for many years and over time you build up a nice sized retirement account into the hundreds of thousands. Still all tied up in your company's stock. The stock has done well and you think it is a great company to work for. You are essentially playing Russian roulette with your retirement. A company going bankrupt and having their stock price go to $0/share is not unheard of. A lot of times it is not easy to see the pending bankruptcy because it happens so fast. The company does not send you a notice saying, "Hey guys, we are going to go bankrupt so you should sell all of your stock." Many people lost a lot of money in the recession started in 2007 when the S&P 500 lost 50%. Can you imagine how you would have felt if you lost everything?
Here are two examples where this actually happened:
Only months before Enron's bankruptcy filing in December 2001, the firm was widely regarded as one of the most innovative fastest growing, and best managed businesses in the United States. With the swift collapse, shareholders, including thousands of Enron workers who held company stock in their 401k retirement account lost tens of billions of dollars
The timeline in the Lehman Brothers descent was even quicker than that of Enron.
8th September 2008
Shares of Lehman plunge 52 percent amid worries the investment bank was struggling to find new investors and raise capital. Reports say the talks with KDB have ended.
10th September 2008
Lehman says it lost $3.9 billion during its fiscal third quarter and plans a number of moves to shore up its balance sheet. The announcement, coming a day after Lehman shares lost 45 percent, is an attempt to assuage market worries. Fuld says the firm will consider all "strategic alternatives."
11th September 2008
Lehman stock plunged 42 percent as the embattled investment bank tried to locate a suitor before more market value and confidence was lost. The stock is down more than 94 percent for the year.
14th September 2008
Lehman Brothers, burdened by $60 billion in soured real-estate holdings, filed a Chapter 11 bankruptcy petition in U.S. Bankruptcy Court after attempts to rescue the 158-year-old firm failed.
Simply stated, if you put too many eggs in one basket, you can expose yourself to significant risk.
In financial terms, you are under-diversified: you have too much of your holdings tied to a single investment-your company's stock. Investing heavily in company stock may seem like a good thing when your company and its stock are doing well. But many companies experience fluctuations in both operational performance and stock price. Not only do you expose yourself to the risk that the stock market as a whole could flounder, but you take on a lot of company risk, the risk that an individual firm-your company-will falter or fail.
These were extreme examples focusing on company stock. To improve your returns it also makes sense to diversify amongst asset classes (Large Cap Stocks, Short Term Bonds, Real Estate, Commodities, Small Cap Stocks, Emerging Markets, ....) This table from Allianz is a great depiction of how the different asset classes performed in the past 10 years.
There are some other principles that I think are worthy of discussion including:
- Carrying high-interest debt
- Start planning too late in life
- Not planning for the unexpected
- Automating your savings plan
But the five that we covered in this article are a great place to start with getting your financial house in order.